Please Learn From My Stupidity

I have a confession to make. My name is Rich, and I'm a stupid investor.

You see, I'm a Freddie Mac (NYSE: FRE) shareholder. I also own a small stake in Fannie Mae (NYSE: FNM) .

But that's not what makes me a stupid investor.

These men are not stupidPlenty of great investors hold shares of the government-sponsored enterprises, including Bill Miller, Rich Pzena, Jean-Marie Eveillard, and David Dreman.

None of these men are remotely stupid. In fact, they are among the most accomplished investors of this generation.

But there's a key difference between those men and me.

OK, two key differencesFor starters, each member of the aforementioned foursome is a far more experienced investor than I am. And that likely goes a long way toward explaining the second key difference between us.

My exposure to Freddie and Fannie was much greater than theirs.

Watching any of your holdings plummet by 85% is painful. But that pain increases exponentially when the sinking stock comprises a significant portion of your portfolio.

In my case, Freddie Mac was my largest individual holding -- by a long shot -- and my failure to practice proper diversification has likely postponed my retirement by a number of years.

Good thing I love my jobI'm not going to lie: My paper losses sting pretty badly right now. But I believe the lesson I learned from this experience will make me a much stronger investor -- and may actually wind up saving me money down the road.

Here it is: It doesn't matter how confident you are in any single company's prospects, or how great you believe your margin of safety to be. In investing, there is always a chance that your company's stock can drop precipitously -- and if you don't take pains to protect your portfolio against this possibility, you're placing your hard-earned assets at risk.

Take Rich Pzena, for example. Freddie Mac was his largest holding, too. But because Pzena owns a broad portfolio containing more than 100 names, Freddie comprised less than 5% of his total assets.

He'd already had a rough go of it so far in 2008, thanks to his heavy exposure to financial stocks like Citigroup (NYSE: C) and Capital One (NYSE: COF) . But his results would have been far worse if he hadn't had some ballast in the form of stable stalwarts like Wal-Mart (NYSE: WMT) and Johnson & Johnson (NYSE: JNJ) .

Diversify, diversify, diversifyDiversification is one of Tom and David Gardner's seven core principles at Motley Fool Stock Advisor. The two Fool co-founders believe that spreading risk across many investments helps investors keep their cool in down markets, while simultaneously building wealth in the long run.

But proper diversification doesn't consist of merely increasing your total number of stock holdings. After all, stocking up on financials, retailers, and homebuilders wouldn't have served you well in this market -- but adding some exposure to energy stocks or utilities would have shielded you from the worst of the recent market slide.

Say whenHow many stocks should you own? That depends on your level of investing experience and risk tolerance.

Warren Buffett famously invested 40% of his capital in American Express (NYSE: AXP) when the company's shares stumbled in the wake of a messy salad oil scandal. The Oracle of Omaha is quite comfortable running a concentrated portfolio of companies in which he has supreme confidence. But as my Foolish friends Brian Richards and Tim Hanson pointed out, Buffett is a better investor than you.

That's why David and Tom argue that you should own at least a dozen stocks, and -- depending on your investing temperament -- possibly many more. As a general guideline, if any single position is keeping you up at night, you're probably not properly diversified.

If you're looking for some solid stock ideas to build -- or round out -- your well-diversified portfolio, consider taking a 30-day free trial of David and Tom's Stock Advisor service. You'll get detailed write-ups of all the brothers' recommendations, as well as their best bets for new money now. Just click here to get started -- there's no obligation to subscribe.

Rich Greifnerowns shares of Freddie Mac and Fannie Mae, but none of the profitable companies mentioned in this article. American Express and Wal-Mart are Motley Fool Inside Value recommendations. Johnson & Johnson is an Income Investor pick. The Motley Fool owns shares of American Express. The Fool has a well-capitalized disclosure policy.

Comments from our Foolish Readers

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It is nice to hear such a public confession of actually losing money in the market. Having balanced articles in which the author confesses to actually losing money allows us fellow Fools to learn from their mistakes. I have made more than my share of mistakes but I always just hear that everyone is always on the right side of any stock movement whether long or short. I think the Fool should write more of these type of articles to allow fellow Fools to learn and analyze the losses.

i'm sorry. it hurts to hear anyone lose like that (it's not hard for any of us to empathize, given the recent market spiral). people do make fortunes on the back of a single company, but they are usually insiders or family members of the founders. the rest of we mortals must rely on diversification, and consequently a slow and deliberate ascention to financial actualization. chin up. scott

If you intend to invest in individual companies, a diversified portfolio of at least 30 assets is required to offer enough protection. You can get many good such company names at fool.com's paid newsletter services or at the CAPS forum. Once you establish a good long list of potential candidates, it is important not to forget the "diversification rule" of not buying too many assets that tend to move together in the same direction.

If 30 assets are too much, you may want to look at index funds or sector ETFs, where fewer holdings can represent whole sectors and not individual companies. The same diversification rule holds though...

You may want to visit http://notiming.com to see the classic MPT portfolio balancing approach in action...

I think diversification is over-rated. The more diversified you are, the more likely you will get market returns. In that case, I'd just buy a market index ETF such as SPY.

The fact that FRE was your biggest holding leads me to believe you are out of touch with the general economy and was oblivious with the unsustained RE market boom. I notice this often with the more affluent.

I feel your pain, i finally got out of Fannie Mae yesterday, i held on thinking that some how investor confidence would some how turn around, licking my wounds this morning I have vowed to turn it all around dust off and get back in there.

We all make mistakes and it's horrible to realize them. It takes guts to admit you've screwed up. All you can do is not let it eat you up and move forward. I wish I had some advice on how to do that, I've made a finanical mistake of my own and its not an easy thing to live with.

Hopefully you candid admission is a lesson for some others to learn before they make a mistake of their own. Never put all your eggs in one basket!

Although diversification is good in theory, for small speculators (cant call myself an investor in all honesty) like me who has less than $10,000 in the market, i don't think its remotely as useful as it is being touted.

At most, i think 2-3 stocks in different sectors should suffice, 4 is pushing it too far.

Diversify in a dozen stocks, with 10,000? Even 100,000? EVEN 1,000,000?

ACAS is my Fannie Mae. I fell in love with the div. and got over exposed. I.m feeling the pain but can't make myself get out and take the a hit. I'm hopeing they can still manage a decent div. until things begin to recover. Insiders arn't selling.........

I still remember when Warren Buffett liquidated his positions in Fannie and Freddie. When asked why all he said was that there were some things on their books he didn't understand. That was enough for me to steer clear.

Unless you have the brilliance and balls of Warren Buffet, a diversified portfolio is the answer. That doesn't mean 50 stocks, but it does mean 12-25 in different industries, different levels of capitalization, and in different sectors of the economy. Know which of your stocks are long-term growth, which are speculative gambles, and which are value oriented pics. Ideally, even in a market like this, you'll have a few high flyers you can sell at a profit along with a few dogs that will take time to come back into the black.

Rich, don't feel too bad; we've all made bad picks (Hmmm, Boston Chicken comes to mind for me, as did a few gold mine stocks I owned through the 90s, but sold before the latest boom). The lesson of diversity is one we need to remind ourselves of, especially in this market that is ripe with potential value relative to the prices we've seen historically. Just remember, every stock can trade lower, regardless of its current price.

I wish I could hit the REC button on this post 1000 times! Hey guys, I believe it's OK to speculate a little, but for God's sake don't play with money you can't afford to lose! And don't put all your eggs in one basket. Especially in an economy as beat up as this one. We've probably all have done it once and the experience will probably make Rich a better trader, but most of you won't take him seriously until you've made the same mistake yourself. I'm here to tell you to take him seriously. If you make the same mistake, it will take a long while to recover and some of you may never recover. I made the same mistake twice myself before I wised up. In both cases it took me more than twice as long to get even as it did to get to my starting position. Remember that it takes a 100% gain to make up for a 50% loss and non-volatile stocks will take longer to make up for volatile ones. I know that most of the stuff you read in investment books say the same thing, but if you write that off because you feel you don't have time for a conservative approach, you may find out that you lost more time than if you would have played by the rules

Buffett's right! Buy when they hate it. I bought 5 stocks this past year and all have been bought out at a nice profit. Now is the time to buy stocks like ETFC which will bloom next year. Mark my words.

Ah sad to see.. I am in a similar situation but not quite to the same extent. I invested positions in Ambac and Washington Mutual. I finally got rid of Ambac last week at 2.35 for around a 50% loss, and I'm still holding onto WM.

I suppose the difference is that I was more diversified. I own 10 stocks -- which admittedly I want to lessen as I think I have a couple duds -- and neither of those positions were my largest holding.

Nonetheless, I look back and feel like a complete idiot for investing in them. For some reason I thought they were over-sold and would recover within a few months, and clearly that hasn't happened yet. I give it a couple years though and I think they will see some improvement. That's why I'm holding onto WM and may consider buying Ambac again if things turn around.

While diversification has its merits, and certainly a larger retirement/income portfolio should be diversified, what would have saved you here would have been a rigid stop-loss strategy. When a fairly stable stock like FRE had been takes a nosedive past its 5 year lows, especially considering the types of home loans that have been made during the bubble, cutting your losses is really not a bad strategy. We can't all be brilliant investors, but we can take certain precautions. I've learned this the hard way, riding too many positions down farther than I believed they would ever go, but the market always overreacts, so I should have known better. Especially if this is a retirement account, and no tax considerations enter into the formula, a stop-loss when those losses reach 20% below recent averages might be a prudent measure.

Sorry you took that kind of beating. I too believe in focusing in on fewer stocks in which I am confident and which I have researched well. Even when you have taken your best shots in the best sectors, etc., the market will often work in a totally illogical, manipulated, herd-mentality fashion. It is imperative to set a rule in stone that you will cut your losses on even your most favorite stock when it closes at 7-8% below your buy price. THIS IS DIFFICULT but it seems to work over the long run by cutting what can be devastating losses. Holding on to stocks that tank (for the "long run") is insanity. You might as well just buy an index fund and take whatever comes along, hoping that the buy and hold works out twenty years down the road. The mortgage debacle just highlights the fact that there are no rules or meaningful punishments for the white-collar elite and their politico cronies. We all pay for their pig-like irresponsibility and greed. Also, watching news and stock movements daily is essential. "Brokers" will advise against this (because they want your business) but if you trade your own account, you need to watch for the inevitable downgrade, poor earnings report, bad international news, etc. to avoid logging into your account and seeing large, irreversible losses. Again, sorry, this trading game is a learning process that is always costly and we have all been through this. Thank you for posting your comment.

I agree that diversification is a reliable method by which you can minimize your losses. However, I do believe that it is possible to be a successful investor without diversifying. The key, I am learning, is to fully comprehend a number of sound and basic business principles and then only invest in the businesses that reflect those principles and measure to a checklist of criteria for investing.

you could also consider investing in yourself right now... come up with an idea a plan and execute... competitors are less likely to react to you because "spending is tight"... not a better time to get into the market for yourself

I'm in my 70's. I'm looking at my "Blue Chip" losses in my IRA's and am now concentrating more in the II recommendations and the MDP recommendations but investing in a wide range of stocks in smaller amounts. I'm also learning to start reducing my holdings in stocks that hit new highs and spread the investments around. I also blissfully invested in some major stock brokerage firms index funds and finally realized after many years that they were underperforming the S&P and many other comparable index funds. I cashed in my index funds and switched them to another brokerage firm who has reinvested them in a wide range of funds that are substantially outperforming the market but with minimal downside exposure. at this stage of my life, I think I finally found the right investment style for myself. By the way, I also subscribe to RYR.

Vancouver investment advisors??- I am a private investor looking for some new ideas from a professional investment firm in Vancouver, BC. Someone is making money through all this turbulence and it isn't me. I already have some conventional advice; what I will be looking for is unconventional advice: shorts, currency plays, offshore stocks, etc. I don't have enough expertise to make these trades myself and need to start my search for alternate professional advice for a portion of my portfolio. Picking through the yellow pages won't do it, so I'm asking for the recommendations of you posters.

PS: one fund that I hold and love is Macquarie Power and Infrastructure (TSX: MPT.UN), currently a 23% yield, with prospects for 2009 looking stable- see their website. Thanks.